Learn more about ROTH IRAs with Shane Tenny, CFP®.
Transcript:
SHANE TENNY: Hey, everyone. Shane Tenny here, managing partner at Spaugh Dameron Tenny, coming to you today to talk a little bit about Roth IRAs.
One of the most common questions we get from clients involves Roth IRA accounts. Everyone seems to have a general idea that Roth IRAs are good, but there's definitely some confusion on exactly why and if high-income families are even allowed to use them.
So, let's start with the first question. What's so great about Roth IRAs?
And to understand this, it's helpful to actually compare them to a traditional IRA. You see, both accounts are limited to an annual contribution of $7,000 (updated for 2024 limits) for people under 50 years old. And that's about where the similarity ends. You see, money that's contributed to a traditional IRA may be tax deductible when it's put in, and there are no taxes due while the money is in the account, presumably growing.
But when you take money out of a traditional IRA, all of the growth will be subject to tax, and probably the principal, too, at whatever tax rate you happen to be in at that time in your life.
With Roth IRAs, however, the contributions that you put in are never tax deductible. However, all the withdrawals you take in retirement are income tax-free. So if you have a long time for money to grow, this can be really beneficial.
Sometimes, I use a little farming analogy to describe this. With a traditional IRA that's tax deductible, you get a tax deduction on the seeds that are planted, but you pay tax on the harvest. Whereas with a Roth IRA, the seeds you plant are after tax. There are no savings on those, but the entire harvest in the future is tax-free.
And so, the next issue that many high-income families have once you're in practice as a physician or a dentist is if you're even eligible to contribute directly to a Roth IRA because of your income. Isn't there some rule that says if you earn too much, you can't use Roth IRAs?
Well, it's true. The IRS rules prohibit anyone who earns over $153,000 a year if you're single or $228,000 a year if you're married from contributing to a Roth IRA. But, those same income limit rules do not apply to IRA contributions. And this opens up a neat little strategy, often called a Backdoor Roth IRA. Essentially, you enter through the IRA, and then you switch to a Roth IRA.
Here's how the Backdoor Roth works. First, you contribute money to a regular IRA. Again, it doesn't matter how much you earn because everyone is allowed to save at least $7,000 (updated to 2024 contribution limits) into an IRA, and the odds are because of your income and other rules, this won't be a deductible contribution for you, which is fine. After the deposit is made, you fill out a form to convert the balance to a Roth IRA.
Now, the devil's in the details here because there's a difference between contributing and converting. Converting is allowed for everyone. Contributing to a Roth IRA is only allowed if your income is below certain limits, but contributing to an IRA is allowed for everyone. So once you convert your non-deductible IRA to a Roth, you can now invest however you want and hopefully grow a whole bunch of money that can all be withdrawn tax-free when you retire.
Obviously, there are some key details and caveats that go into this whole topic, so make sure you consult with your CPA or tax preparer first. But hopefully, now you have a little better idea of the difference between IRAs and Roth IRAs and how even high-income families can start building tax-free money.
For more information, you can download our blog on the tax forms required for Roth conversions or just drop us a line.
We'll be happy to answer any questions and see if we can be of help. Thanks so much. We'll see you back here next time.